beneficiary] creates opportunities for the unintended and inappropriate use of section 529 plans. For example, taxpayers may seek to use section 529 accounts as retirement accounts, with all the tax benefits but none of the restrictions and requirements of qualified retirement accounts, or to avoid gift and GST taxes by changing the [designated beneficiary] of existing section 529 accounts. The Administration stated that the law "should be clarified to provide taxpayers with certainty as to the tax consequences of a transfer and to eliminate the inappropriate imposition of transfer taxes."942 ,,941 Subjecting qualified tuition accounts to generally applicable transfer tax provisions would reduce the potential for abuse by taxpayers who establish such accounts with no intention of ultimately providing education benefits to other persons, and would put qualified tuition accounts on a more level playing field with other tax incentive vehicles such as IRAs, while retaining the substantial income tax benefits provided by the present-law section 529 provisions for qualified tuition accounts. Under the proposal, a taxpayer could treat the contribution of amounts to a qualified tuition account as a completed gift, excludable from his or her estate, only if he or she relinquished control over the use and enjoyment of the account. Other potential solutions offered to prevent abuse of the accounts, such as imposing aggregate quantitative percontributor or per-beneficiary limits on contributions or account balances, would be difficult to administer because they would require coordination of recordkeeping and reporting by the various State-sponsored and private qualified tuition programs. In addition, the present-law provisions cannot be made consistent with generally applicable transfer tax principles without materially altering the structural design of most qualified tuition programs. Transfer tax deficiencies of present-law section 529 Section 529 does not explicitly address the transfer tax consequences of certain events that are commonplace under existing qualified tuition programs. For example, section 529 does not address the transfer tax consequences of a change of account owners of a qualified tuition account. It is unclear whether a change of account owner is to be regarded as a completed gift of a present interest from the former account owner to the new account owner, or as having no tax consequences because a completed gift had been made to the designated beneficiary. Further, section 529 does not identify which party is responsible for payment of the transfer tax when it is imposed (i.e., in instances involving a change of designated beneficiary to a person who is in a 941 Department of the Treasury, General Explanations of the Administration's Fiscal Year 2005 Revenue Proposals, February 2005, 136-37. 942 Id. The Administration's proposal generally would modify certain income tax, gift tax, generation-skipping transfer tax, and estate tax rules with respect to changes in designated beneficiaries of qualified tuition accounts, impose new eligibility rules for designated beneficiaries, require that a qualified tuition account be a custodial arrangement maintained for the benefit of a designated beneficiary, and impose new excise taxes on amounts that are used other than for qualified higher education expenses. For a description and analysis of the Administration's proposal, see Joint Committee on Taxation, Description of Revenue Provisions Contained in the President's Fiscal Year 2005 Budget Proposal, (JCS-3-04), February 2004, 306-17. generation lower than the former beneficiary). In such cases, it is not clear whether the gift tax should be imposed on the former designated beneficiary, the original contributor, the account owner, or perhaps on the account. This lack of clarity creates complexity for taxpayers in arranging their affairs, and for the IRS in attempting to administer the present-law rules. 944 943 In addition, section 529 departs from otherwise generally applicable transfer tax principles in at least five ways. First, present-law section 529 treats a contribution to a qualified tuition account as a completed gift of a present interest to the designated beneficiary, even though in most instances the designated beneficiary possesses no rights to control the qualified tuition account or withdraw funds, and such control (including the right to change beneficiaries or to withdraw funds, including for the benefit of someone other than the designated beneficiary) is vested in the account owner. Second, a change of designated beneficiary to a new beneficiary who is in a generation lower than the former beneficiary constitutes a taxable gift, even though the new designated beneficiary would not, under otherwise applicable transfer tax principles, be regarded as receiving a completed gift. Third, an account owner is not required to include in the account owner's estate the amount held in a qualified tuition account, even if the account owner possesses at his or her death the right to withdraw funds for the benefit of someone other than the designated beneficiary or to change the designated beneficiary. Fourth, a distribution from a qualified tuition account is not treated as a taxable gift unless the distributee is of a generation lower than the designated beneficiary. Fifth, under present-law section 529, there is no express requirement that the multiple annual present interest exclusion is 943 944 Sec. 529(c)(2). 946 945 Absent section 529, such contributions generally would not be treated as completed gifts to the designated beneficiary under otherwise applicable transfer tax principles. Under otherwise applicable transfer tax principles, the designated beneficiary's lack of control over the qualified tuition account generally would be regarded as a future interest, and any completed gift of a present interest would be regarded as having been made from the contributor to the account owner (rather than to the designated beneficiary). In cases where the contributor and the account owner are the same person, no gift would take place under generally applicable transfer tax principles. 945 Under otherwise applicable estate tax principles, the account owner generally would be regarded as possessing rights with respect to the qualified tuition account that cause the account balance to be includible in the account owner's estate for Federal estate tax purposes. See, e.g., secs. 2036 and 2038. 946 Under otherwise applicable principles, such distributions would be a taxable gift by the account owner unless the account owner has an obligation to provide such benefits (e.g., the beneficiary is a dependent of the account owner and is obligated to provide education support under State law) or the distribution is a direct purchase of tuition from the school by the qualified tuition account (and would be excludable under section 2503(e)). This exclusion for distributions made to a person who is of a generation of the same generation of the designated beneficiary seems to apply even if the distribution is used by the designated beneficiary other than for qualifying educational expenses. available only if there is a present intent to allow the designated beneficiary to receive the benefits of the qualified tuition account. 948 947 949 For example, under present-law section 529, a taxpayer might establish 20 separate qualified tuition accounts for 20 separate designated beneficiaries, and immediately deposit $55,000 in each account. By doing so, the taxpayer may treat the full amount of each contribution as a completed gift to the designated beneficiary, elect the section 529 five-year annual exclusion treatment for each of the contributions, and exclude the entire $1.1 million (up to $2.2 million under gift-splitting) from estate, gift, and GST taxes. Under present law, the taxpayer may be the account owner with respect to each of these accounts, which under many qualified tuition programs permits the taxpayer to control the account through changes in the designated beneficiary and the withdrawal of funds for any purpose. The taxpayer has avoided the imposition of the estate, gift, and GST taxes even if the account ultimately is not used for education purposes. The taxpayer also may avoid imposition of the GST by designating beneficiaries who are in generations more than one generation below the generation of the taxpayer. Because section 529 imposes no restrictions on the identity or number of persons for whom qualified tuition accounts may be established, or to which contributions may be made, it has been suggested that the literal application of section 529 could permit a closely-held business employer to establish qualified tuition accounts for each of its employees, and later change the beneficiaries of the accounts to a single individual, without incurring transfer taxes on the transfers to the accounts. 950 951 947 Thus, a contributor may make contributions eligible for multiple $11,000 annual exclusions by naming multiple beneficiaries of multiple qualified tuition accounts, even if the contributor has no present intent to allow the named beneficiaries (or any beneficiaries) to receive any benefits from the accounts. 948 The taxpayer might deposit $110,000 in each account if he or she is married and elects with the spouse to gift-split for annual exclusion purposes. 949 A taxpayer who makes the special five-year ratable allocation annual exclusion election is required to include a portion of the contribution in his or her estate if he or she dies within five years of making the contribution. 950 The distribution of the funds for uses other than qualifying educational expenses will be subject to income tax, and an additional 10-percent tax, however, on the earnings portion of the distribution. 951 Letter from Carlyn S. McCaffrey of the American College of Trust and Estate Counsel to the Internal Revenue Service, February 25, 2003, Q/A-21 Abusive Situations (providing a similar example in the employer-employee context, and noting that section 529 might permit a father that owns a business to transfer $1,000,000 gift tax-free to his son through the use of section 529 accounts initially established for employees, and stating that the College does not believe that Congress intended to undermine the integrity of the gift tax system by enacting section 529). Some might argue that the proposal effectively eliminates transfer tax benefits for most qualified tuition programs, and that retention of the special transfer tax principles of present law is desirable to encourage savings for educational purposes. Others might argue that the proposal does not go far enough to maximize the likelihood that the account ultimately is used for educational purposes, and would endorse the imposition of an excise tax (in addition to the present-law additional 10-percent tax) in cases where monies are withdrawn for noneducational purposes. Such an excise tax might be limited to cases where the withdrawal is for the benefit of someone other than the initial designated beneficiary, because in such cases additional transfer tax benefits (such as through generation skipping) might have been derived from the arrangement. |